Saudi Oil Supply and Production

Stuart Staniford has an interesting post over at the Oil Drum about the decline on Saudi oil production and suggests that the decline isn’t voluntary and that the Saudi’s are facing a serious production constraint.

When economies grow well, people build more houses, take more vacations, and buy more goods and services. Businesses hire more workers, send staff on more business trips, and open new offices and factories. All these things increase the demand for oil to power cars, trucks, planes, heating systems, etc. Thus the usage of oil is highly sensitive to economic growth – indeed economic growth has a far stronger effect on oil demand than the price of oil (an economist would say that the income elasticity of oil demand is much larger than the price elasticity).

As the swing producer, historically Saudi Arabian oil production has varied widely based on oil demand – they reduce production the most when demand drops, and they were best placed to make very large increases in production when there was a sudden need in the market for more oil.

[…]

A-priori, in the face of steady economic growth like this, we would have expected world oil usage to increase several percent a year throughout the period of interest, and we might have expected Saudi production in particular to increase. The production increase in 2002 may well have this character, as may the increase from 2002 to 2004 and then to 2004 (though other factors enter the picture here as discussed in a moment). However it is striking that increases in production essentially ceased after a last step up in mid 2004, despite continued economic growth. This is surprising in the historical context.

In other words, since oil is (positively) correlated with economy growth and Saudi Arabia acts as the swing producer to keep prices somewhat stable, we should have seen more production increases than have been observed based on historical data. That we haven’t seen such production increases is significant.

Stuart also points to another interesting phenomenon: the futures market and oil stocks. Over the past several years U.S. and OECD oil stocks have been increasing. Why is this interesting? It suggests that traders on commodity markets think that the price of oil is going to go up. Think of it this way, suppose you have a commodity that is currently priced at $5 today, but a year from now you expect the price to be $15. Should you sell today or hold on to it for year? Holding on to it requires storage so you’ll incur storage costs. So long as the storage costs are below $10 you should hold on to the commodity for later sale. Now actual markets are more complicated in that the future price is not known with certainty, but taking those kinds of risks are what commodity traders often do. So, the increase in oil stocks suggests that the recent price increases might not be finished and that the price of oil could go up even further. However, even with these increasing stocks, the “Days of Supply of OECD Commercial Oil Stocks” has been declining. The reason is obvious, the economic growth has increased demand and even the increases in oil stocks hasn’t been enough to keep pace in terms of “Days of Supply”.

What does it all mean? Well, Stuart sees the decline continuing for awhile then moderating to some degree as the Kingdom of Saudi Arabia (KSA) goes after smaller fields. But this wont help the oil situation much in that KSA will see a drop in their production capacity and it will mean that oil prices will likely remain high for quite sometime. Still the world economies should be able to adjust.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Bithead says:

    Might there be a sociao-political motivation at work here on the part of the house of Saud?

  2. John Burgess says:

    This analysis works only if one assumes that the Saudis are lying about their reserves. If they are telling the truth, then it fails miserably.

    And the trick is that the Saudis prefer to tell their story themselves, considering their oil reserves a matter of national security. No matter how helpful it might be to investors to have precise and verified numbers, that’s not the Saudis’ main interest. So, at best we’re working with imperfect information.

    Given the level of foreign investment in Saudi oil, one has to conclude that a) oil companies place a high level of trust in Saudi figures or b) oil companies are dumb as bricks. If one bases one’s conclusion on the general success of oil companies, you have to lean toward a). ‘Peak oil’ analyses, however, tend to come from contrarian investment analysts with rather transparent objectives.

    Again, I’ll have to cite the NY Times piece on Saudi reserves, and other media media reports that the KSA is, in fact, increasing oil production.

  3. Steve Verdon says:

    John,

    No, not necessarily. There are issues such as letting a field rest to avoid water break throughs and other production constraints that take time to over-come. Staniford mentions that there are other fields and that nobody is this pessimistic (i.e. the production decline will continue until production is zero) about Saudi reserves.

    As for the reports of increasing reserves, Staniford has several sources that all show a decline. While the actual levels might be in dispute he figures the trends are more likely accurate at least in qualitative terms.